Tax-Free Money: The Medicare Retiree Drug Subsidy

Editor: Mary Van Leuven, J.D., LL.M.

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003
(MMA), P.L. 108-173, amended Title XVIII of the Social Security Act (SSA) by establishing Part D: Voluntary Prescription Drug Benefit Program. This program adds certain prescription drugs to the benefits covered under the Medicare program, effective Jan. 1, 2006. In addition to prescription drug benefits covered either by private drug plans or through a Medicare plan, the MMA also authorized a Medicare Retiree Drug Subsidy (RDS) program for qualifying group-health-plan sponsors. It also created Sec. 139A, which excludes payments received under the Medicare RDS program from taxable income.

Medicare RDS

The Medicare RDS is aimed at employers and unions (collectively, “employers”) that offer private prescription drug coverage to their retirees and other qualified individuals (collectively, “retirees”) under a group health plan. The RDS provides financial incentives, in the form of direct payments, to employers to continue to provide prescription drug benefits for their retirees, instead of abandoning the plans in response to the inclusion of such benefits under Medicare. Both tax-exempt and taxpaying employers and unions are eligible for subsidy payments, which are intended to reduce or eliminate employer costs of contributions to prescription drug coverage plans for retirees.

The subsidy can be claimed for each individual enrolled in the employer’s plan who is eligible for Part D but elects not to enroll in it. The subsidy payments equal 28% of each qualifying retiree’s allowable prescription drug costs attributable to gross prescription drug costs between the applicable cost threshold and cost limit (for 2006, between $250 and $5,000 per retiree; the amounts are adjusted annually based on average per-capita aggregate expenditures for Plan D drugs by eligible beneficiaries for plan years ending after 2006). The allowable retiree’s prescription drug cost is the amount actually paid by the drug plan or the retiree (or on the retiree’s behalf), net of any discounts, chargebacks, rebates or other similar price concessions. The computation of the subsidy payment to the employer applies not only to amounts actually paid by the plan or the employer, but also to a retiree’s payments. In December 2005, the Center for Medicare and Medicaid Services (CMS), which administers the subsidy program, provided guidance for the treatment of account-based health arrangements under the RDS. Although payments made from an Archer medical savings account or a health savings account cannot qualify for RDS payments, if a health reimbursement arrangement (as described in Rev. Rul. 2002-41 and Notice 2002-45) or flexible spending account otherwise meets the standards applied to other group health plans, such plans may qualify for the RDS.


To be eligible for the RDS program for any plan year, employers must submit an application to the CMS no later than 90 days before the beginning of each plan year. The employer must attach to such application an actuary’s attestation that the value of the coverage offered under the employer’s plan at least equals the value of standard prescription drug coverage, and provide information regarding the plan’s enrollees and certification that the credible status of the plan has been or will be disclosed to plan participants and the CMS. Employers must provide substantial additional information (aggregate data about drug costs incurred) with their applications for payments under the RDS, in addition to monthly updates of their plan’s enrollment information. RDS program applications must be submitted by employers for each plan year.

The CMS estimates that employers who choose to participate in the RDS program will receive an average of $668 per eligible retiree. Under Sec. 139A, the payments received by an employer under the RDS are not includible in gross income. An employer may annually elect to receive RDS payments monthly, quarterly or annually. Employers that elect periodic payments (i.e., monthly or quarterly) must submit data in the same frequency as the payments are requested and submit a final year-end reconciliation.


Because this provision of the SSA is new, the subsidy benefit may not have received attention from taxpayers. Because it represents tax-free income relating to expenditures already borne by most employers, the RDS program should not be overlooked. Further, the RDS payments may not be readily identifiable in a business’s financial accounts, because some companies may treat the subsidy as a reduction to their health-benefit costs and not as an income item.

The statute creating the RDS is SSA Section 1860D-22. Final rules for payments to sponsors of retiree prescription drug plans are provided in 42 CFR 423.880–423.894 (1/28/05). A discussion of the proposed rules and comments received is provided in the Federal Register, Vol. 70, No. 18, pp. 4400–4417.

From Frank J. Kalis, Jr., CPA, and Alexa Mortenson Claybon, J.D., LL.M., Washington, DC


Mary Van Leuven, J.D., LL.M. is a Senior Manager at Washington National Tax KPMG LLP in Washington, DC.

Unless otherwise indicated, contributors are members of or associated with KPMG LLP. The views and opinions are those of the authors and do not necessarily represent the views and opinions of KPMG LLP. The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.

© 2007 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved.

If you would like additional information about these items, contact Ms. Van Leuven at

Tax Insider Articles


Business meal deductions after the TCJA

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.


Quirks spurred by COVID-19 tax relief

This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19.